Taking Advantage of the Dow-to-Gold Ratio (DIA, GLD)

After living in fear of European central bank gold sales for most of the past decade, it caught many outside observers by surprise to watch the yellow metal regain its former glitter, and surge as high as $730 per ounce on May 12th, its highest in 26 years. But just as quickly as gold sprinted to record highs, it started to spiral lower into a tailspin, plummeting $190 /oz to as low as $542 /oz just four weeks later.

Gold is on a wild rollercoaster ride, and only the most agile and quick footed speculators are profiting on both sides of the market. Gold’s spectacular climb was widely attributed to super easy monetary policies in Europe and Japan, and the appointment of Federal Reserve chief Ben Bernanke, with a reputation as a super dove, willing to print money and drop dollar bills from helicopters to fight deflation.

Gold also found its natural place within the “Commodity Super Cycle” moving higher alongside commodities in tight supply, such as copper, crude, oil, platinum, and zinc, all soaring to stratospheric heights and pointing to higher inflation. And in the background, was speculation that the central banks of China and Russia were disenchanted with the US dollar, and seeking to diversify their combined $1.1 trillion of foreign currency reserves into hard money such as gold.

The big-3 central banks, the Bank of Japan, the European Central Bank, and the Federal Reserve, were reluctant to combat the “Commodity Super Cycle” and record high oil prices with aggressive rate hikes, and instead, prayed that the speculative bubble would burst under its own weight. However, on May 8th, central bankers from the leading ten industrial nations decided to take concerted action to combat commodity inflation, by lifting interest rates together for the first time in a decade.

Jean-Claude Trichet, spokesman for the G-10 group of central bankers, admitted on May 8th that inflationary expectations were starting to rise during a period of high commodity and energy prices. "It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation,” Trichet told a media briefing.

Soon after, central banks from 20 countries around the globe began to lift their lending rates, triggering panic in developed and emerging stock markets. Even China and India entered the fray, by taking actions to reduce their money supplies, which are expanding at an annualized 19.1% and 18.5 percent.

The ambush by the G-10 and their new found allies caught hedge fund traders by surprise, and created a sense of panic, leading to liquidation of commodity positions across the board, knocking super stars such as copper and zinc about 20% below their record highs, while gold tumbled as much as 26%. However, crude oil remained resilient with a smaller 7% setback.

But deeply skeptical gold bugs wanted real proof that the G-10’s anti-inflation rhetoric was not just lip service, before dumping the yellow metal. The evidence was found amid the carnage of the global stock market meltdown that wiped out $2 trillion of market value from Morgan Stanley World Index, a basket of 23 developed country stock indexes, representing 86% of the world economic output. A global stock market meltdown puts the “reverse wealth” effect into motion, by undermining consumer confidence and spending, and thereby putting a lid on inflation pressures.

Most interesting, there has been a recent evolution of market psychology, expressed by the close correlation between gold prices and major stock market indexes. In the US, gold is closely tracking the direction of the Dow Jones Industrials, and the only question is which market will outperform the other. Such a tight relationship stands in stark contrast to the inverse correlation witnessed in 2000 thru 2002.

For instance, since hitting bottom on June 13th at the 10,700-level, the Dow Jones Industrials have rebounded 550 points or 5.1% higher, while gold prices rose 16% or $88 /oz to as high as $630 /oz ounce on July 5th. What the charts above show is that gold outperformed the DJI when both markets were moving higher. Conversely, the DJI has outperformed gold when both markets were moving lower.

What’s the rationale for these phenomena? One plausible explanation is that global stock markets are real time indicators about the direction of the global economy with hidden clues about aggregate demand for commodities, and by extension, inflationary pressures. In other words, weak stock markets signal deflation and rising stock markets signal inflation pressures. The level of the stock market also provides clues about the degree of liquidity in the market provided by the central bank.

How can one play the Dow Jones Industrials (NYSEARCA:DIA) to gold (NYSEARCA:GLD) ratio? If the Federal Reserve takes a pause in its rate hike campaign in August, as widely expected, both DIA and GLD could climb higher. However, crude oil and other metals might also join the upside bandwagon, exerting upward pressure on inflation. Under that scenario, traders could buy GLD and simultaneously short DIA as a spread.

As inflation pressures begin to build up in the commodities markets, the bond market vigilantes might start to jack-up long term bond yields. That scenario still favors the long GLD and short DIA spread. However, once it becomes more evident that the Fed has been pushed into a corner and forced to hike the fed funds rate to 5.50% at its meeting in September, traders would then start to unwind the long GLD short DIA spread, as the Fed takes belated action to combat inflation.

However, if the Fed surprises the market with a quarter-point rate hike on August 8th, shorting GLD and buying DIA makes more sense. Between now and the next Fed meeting on August 8th, both DIA and GLD will gyrate widely on each economic statistic and Fed jawboning that hits the wires.

The Fed is now shooting from the hip, with no sure game plan of how to move forward on interest rates. Its hesitancy leans in favor of a pause in August, letting the inflation genie out of its bottle, and favoring long GLD and short DIA spreads in the month of July.

The initial downside target for the short DIA and long GLD spread is a ratio of 16. Of course, nothing is guaranteed in the markets, so short DIA and long GLD spreads would be stopped out at 20.5 ounces of gold. Based on current market values, every 100 shares of DIA should be balanced with a position of 182 shares of GLD.